WORKING PAPER SERIES / COLLECTION DOCUMENTS DE TRAVAIL

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1 WORKING PAPER SERIES / COLLECTION DOCUMENTS DE TRAVAIL UNBUNDLING CANADA S WEAK PRODUCTIVITY PERFORMANCE: A REVIEW OF THE ISSUES Susanto Basu, Boston College Workng Paper

2 The Economc Research and Polcy Analyss Branch s Workng Paper Seres s ntended as a means of dffusng research fndngs from Industry Canada projects for dscusson and comment. Workng Papers are crculated n the language n whch they were wrtten. The papers reflect the vews of the authors and no responsblty for them should be attrbuted to Industry Canada or the federal government. Comments on the papers are nvted and may be sent drectly to the authors. La sére Documents de traval de la Drecton générale de la recherche économque et de l analyse des poltques se veut un moyen de dffuser les résultats des recherches ssues des projets d Industre Canada dans le but de favorser la dscusson et la récepton d observatons. Les documents de traval sont dffusés dans la langue dans laquelle ls ont été écrts. Les opnons qu y sont exprmées sont celles des auteurs et n engagent pas Industre Canada ou le gouvernement fédéral. Le lecteur est pré de fare part de ses commentares aux auteurs.

3 Workng Paper Seres / Collecton Documents de traval UNBUNDLING CANADA S WEAK PRODUCTIVITY PERFORMANCE: A REVIEW OF THE ISSUES Susanto Basu, Boston College Workng Paper IC To obtan copes of documents publshed under the Workng Paper Seres, please vst: or contact: Publcatons Coordnator Mcro-Economc Polcy and Analyss Industry Canada 10 th Floor, East Tower 235 Queen Street Ottawa, Ontaro K1A 0H5 Tel.: (613) ; Fax.: (613) E-mal: erpa-reap@c.gc.ca Pour obtenr des exemplares des documents publés dans la collecton des documents de traval, clquer sur : ou s addresser à : Coordnatrce des publcatons Analyse de la poltque mcro-économque Industre Canada 10 e étage, tour Est 235, rue Queen Ottawa (Ontaro) K1A 0H5 Tél.: (613) ; Fax.: (613) Courrel: erpa-reap@c.gc.ca

4 Acknowledgements I am grateful to Guseppe Ncolett, Someshwar Rao, Stefano Scarpetta, Fabo Schantarell and Janmn Tang for comments and suggestons. All errors and nterpretatons are mne.

5 Abstract Canada s one of the few OECD countres to tral the Unted States n both the level and growth rate of productvty over a long perod of tme ( ). Ths paper suggests a method for breakng down ths productvty gap nto three components: dfferences n allocatve effcency, the effects of scale economes, and a resdual. The resdual, n turn, s a functon of a varety of factors, ncludng management practces, nfrastructure, and nnovatve actvtes such as R&D. Spendng on nnovaton has drect benefts and also creates postve externaltes. Measurng the contrbuton of all these components of productvty growth requres both frm-level and aggregate data. The paper then revews efforts to fnd how economc polces work through these varous channels to affect aggregate productvty. It concludes that regulaton and economc polcy clearly have a statstcally sgnfcant effect on productvty. But there s not yet clear evdence on the economc sgnfcance of the effects. Establshng the lkely quanttatve mportance of plausble polcy changes s the hghest prorty for future research. Key words: productvty, Canada-U.S. productvty gap, nnovaton, regulaton Résumé Le Canada est un des rares pays de l OCDE à se lasser dstancer par les États-Uns sur le plan de la productvté (nveau et crossance) sur une longue pérode ( ). Cette étude présente une méthode pour décomposer cet écart de productvté en tros éléments : les dfférences dans l effcence allocatve, les effets des économes d échelle et un résdu. Le résdu est foncton de dvers facteurs, dont les méthodes de geston, l nfrastructure et les actvtés d nnovaton, comme la R-D. L nvestssement dans l nnovaton produt des retombées drectes ans que des externaltés postves. Pour mesurer la contrbuton de tous ces facteurs de crossance de la productvté, l faut des données sur les entreprses et des données globales. Cette étude examne ensute les travaux réalsés en vue de détermner dans quelle mesure les poltques économques agssent sur la productvté globale par l ntermédare de ces facteurs. L étude permet d établr que la réglementaton et la poltque économque ont clarement un effet statstquement sgnfcatf sur la productvté, mas l mportance économque de cet effet n est pas encore étable. La quantfcaton de l mportance des changements qu pourraent être apportés à la poltque économque est un sujet hautement prortare pour la recherche future. Mots clés : productvté, écart de productvté entre le Canada et les États-Uns, nnovaton, réglementaton

6 Canada and the Unted States share many characterstcs n common democratc government, hgh ncome, North Amercan geography, and a basc commtment to both free markets and socal justce, to name just a few. Thus, t s surprsng that the relatve labor productvty performance of the two countres has dverged steadly over tme. Ths paper sketches a path for uncoverng and analyzng the causes of that gap. Important papers by Statstcs Canada (2007) and by Rao, Tang and Wang (2008) document the facts that should be the startng pont for analyss. Statstcs Canada (2007) shows that for about 20 years, labor productvty has grown more slowly n Canada than n the Unted States. Rao, Tang and Wang (2008) show that ths gap s not unform across ndustres. The gap n growth rates was much larger for manufacturng than for the busness sector as a whole, although both gaps show an acceleraton snce about the year 2000 that s, Canada fallng behnd faster snce 2000 than t was before. But nterestngly, n several ndustres (notably Constructon, Prntng and publshng, Non-metallc mneral products, and Prmary metal products) Canada not only had a lead n labor productvty n 1997, but extended that lead through In other ndustres, (for example, Food and Chemcals), Canada was tralng the Unted States sgnfcantly n 1997, but had essentally acheved party or a bt better by Of course, n stll other ndustres, Canada fell behnd the Unted States over the perod, leadng to ts aggregate relatve labor productvty declne. But t s mportant to note the dvergent performance of these ndustry groups, because the proposed explanaton(s) should be capable of explanng not only the aggregate gap, but the heterogeneous performances of the dfferent ndustres. Ths paper wll take the stand that to understand the labor productvty dfference between Canada and the Unted States, t s essental to understand the source of the dfferent rates of TFP 1

7 (MFP) growth between the two countres. There are three reasons for ths approach. Frst, Statstcs Canada (2007) documents that over the dfference n TFP growth between the two countres accounts for more than 100 percent of the labor productvty gap! Clearly, dfferental TFP performance s a major drver of the dfference we seek to explan. Second, over long perods of tme, captal ntensty (the second component of labor productvty growth) s endogenous, and should be drven by TFP growth. Thus, accordng to smple economc models, n the long run TFP should be the sole drver of labor productvty growth, and hgh TFP, hgh labor productvty and hgh captal ntensty should all go together. 1 Thrd, as Hulten (2001) remnds us, TFP growth s the free part of mprovement n lvng standards. Rasng captal ntensty may have long-run benefts, but t also has short-run costs: n order to nvest more, people need to lower consumpton n the short run a length of tme that n ths context mght be measured n decades. Thus, rasng TFP growth s partcularly mportant for mprovng lvng standards and economc wellbeng at all tme horzons. The remander of the paper s structured as follows. In Sectons I and II, we lay out a smple framework for analyzng dfferences n TFP growth rates between Canada and the Unted States at the ndustry level. Applyng ths framework wll help llumnate the reasons why Canada s TFP performance has consstently lagged that of the Unted States, and allow us to understand the causes of the large and growng gap n labor productvty levels between the two countres. In Secton III, we dscuss potental reasons for the gaps we seek to explan, drawng on the results of the framework sketched n the prevous sectons. I. Defntons 1 Indeed, ths predcton s consstent wth the fndngs of Rao, Tang and Wang (2008, p. 12) when studyng labor productvty gaps ndustry by ndustry: Across the 29 ndustres, there s a sgnfcant postve correlaton between the labor productvty and captal ntensty gaps. In other words, the ndustres n whch Canada has a productvty advantage are also generally the ndustres n whch we have a captal ntensty advantage, and vce versa (Table 4). 2

8 There are N goods n the economy. Frms, ndexed by, produce goods by hrng labor,, L and rentng captal, K. We assume that only one frm produces each good. 2 When there s no ambguty, we omt tme subscrpts. We assume that there s only one type of labor and one type of captal, and so we defne aggregate nputs as smple sums of the frm-level quanttes: K L The assumpton of homogeneous captal and labor s made for smplcty. Wth heterogeneous captal and labor, we would sum over each nput separately; nothng fundamental would change. N 1 N 1 In prncple, dfferent frms may pay dfferent prces, even for a homogeneous nput (for example, f unons rase wages at some frms but not others). For any nput J, let P J be the prce t pays to rent or hre the nput for one perod. We defne the aggregate (rental) prces of captal K, L. and labor as the factor payments dvded by aggregate quanttes: P K P K N 1 K K, P L PL N 1 L L. We denote the growth n the Dvsa defnton of aggregate output (equvalently, aggregate value added) by dv. We defne aggregate nputs and aggregate productvty n the ways we use them throughout the paper. We defne the share of each nput J n aggregate value added as s V J P J P V V V. Aggregate nputs, dx, are then a share-weghted sum of prmary nputs of J captal and labor: 2 Ths s not a restrctve assumpton, snce we can ndex goods by the frms that produce them. Consumers may regard two goods as perfect substtutes, mplyng that they have dentcal prces. More restrctve s our mplct assumpton of a fxed number of frms. 3

9 dx V s V dk s V dl. (1) The shares are the aggregate cost of each nput dvded by total nomnal revenue; note that n K L contrast to Solow (1957), we do not take captal s share as a resdual. Thus, s K V V and s sum to L less than one f frms make economc profts. We defne aggregate productvty growth as output growth mnus nput growth: dp dv dx V. (2) If there are economc profts, then our measure of productvty dffers from Solow s because nput weghts do not sum to one. If economc profts are zero, then our weghts and hence our productvty measure match Solow s. Gven that pure profts appear small (Basu and Fernald (1997a); Rotemberg and Woodford (1995)), n practce our measure s very close to Solow s. II. Productvty and Technology Ths secton lays out our method for fndng the deep determnants of TFP growth n Canada and the Unted States. We begn by consderng TFP growth at a frm level, and then aggregate over frms to get ndustry-level productvty growth. We begn wth frm-level producton functons for gross output, and then derve the valueadded analogues. We focus on frm-level value added because of our ultmate nterest n economy-wde aggregates. Aggregate fnal expendture prvate and publc consumpton, nvestment, and net exports measures what socety consumes today or saves for tomorrow. The natonal accounts dentty shows that aggregate fnal expendture equals the aggregate of frm-level value added ntermedate-nput use cancels out. Thus, aggregatng frm-level value added leads to economcally sensble aggregates. Subsecton A analyzes the determnants of frm-level value added and productvty. Subsecton B uses those mcrofoundatons to analyze ndustry output and productvty. 4

10 A. The Frm Level We assume each frm has a producton functon for gross output: Y F K, L, M, T, (3) where Y s gross output, K, L, and M are nputs of captal, labor, and materals, whch are purchased by the frm. T ndexes all other nputs that affect producton, but are not drectly compensated by the frm. Ths ncludes exogenous technology, but also other factors that are dscussed n Secton III.D. The frm's producton functon F may be (locally) homogeneous of arbtrary degree n K, L, and M. s not constraned to be one, so F may have nonconstant returns to scale. Each frm may produce ntermedate goods, fnal goods, or both. We assume that frms are prce takers n factor markets, but may have market power n output markets. For any nput J, let F J be the margnal product. Frm s frst-order condtons then mply that the value of the margnal product s proportonal to the shadow rental cost of that nput, P J : 3 PF P. (4) J J Frms may charge a markup,, over margnal cost: P MC, where MC s margnal cost. By defnton, returns to scale equals the sum of the output elastctes wth respect to all nputs. Combnng ths wth the frst-order condtons, t s straghtforward to fnd the relatonshp among,, and the rato of economc proft to total revenue, s : (1 ). s (5) Below, we emphasze markups rather than returns to scale, snce the markup determnes how the socal and prvate valuatons (.e., the margnal product and the nput prce) of a factor dffer. 3 For the dstncton between the prce pad to a factor and ts shadow rental cost, see Berndt and Fuss (1986). 5

11 However, the equaton above shows the close relatonshp between returns to scale and mperfect competton: frms wth ncreasng returns must charge markups to cover ther costs. If economc profts are small, and must be approxmately the same. If returns to scale dffer across frms for technologcal reasons (such as dfferences n fxed costs), then markups are lkely to dffer. Followng Hall (1990), cost mnmzaton 4 mples that output growth, dy, equals the markup multpled by revenue-share-weghted nput growth, dx, plus gross-output-augmentng FT T technology change, dt F nomnal gross output and dj s the nput s growth rate,. So for any nput J and frm, where s J s the nput s share n FT FT dy sldl skdk smdm dt dx dt F F T T. (6) The revenue shares need not sum to one f there are economc profts or losses; otherwse, our revenue shares concde wth Solow s shares. Note that equaton (6) apples at an nstant n tme; n prncple, the elastctes, and the markup may vary over tme. Thus, the economc framework mposes no assumpton of constant markups, but for econometrc mplementaton n dscrete tme, we later estmate only the steady-state markup and gnore ts possble tme varaton. Ths procedure s consstent wth a frst-order log-lnearzaton of the producton functon, equaton (3). Snce our ultmate nterest s n value added, we now derve the value-added analogues to (6). From the producton sde, we use the standard Dvsa defnton of frm-level value-added, : dv 4 Contrary to some of the statements n the lterature, the dervaton does not requre proft-maxmzaton. Hence the relatonshp we derve below s robust to any form of prce-settng behavor; for example, t allows for stcky output prces and for complex dynamc prcng strateges derved from supergames (e.g. Rotemberg and Saloner [1986]). In partcular, note that markups need not depend just on the elastcty of demand. 6

12 dv dy s Mdm s M dy 1 s M 1 s M ( dm dy). (7) where: Wth some algebrac manpulaton, we can wrte as: dv s V V V M dv dx 1 dm dydt. (8) 1 sm V sk 1 sl 1 V V dx dk dl skdk sldl s s. (9) M M V 1 s 1 s M M, (10) dt FT T dt F 1 s M. (11) From equaton (8), real value-added growth depends on prmary nput growth, changes n the materals-to-output rato, and a resdual that ncludes technology change. The frst term shows that prmary nputs are multpled by a value-added markup. The second term reflects the extent to whch the weght on materals-nput-growth n equaton (7) does not properly measure the productve contrbuton of ntermedate nputs. Intutvely, the standard measure of value added subtracts off ntermedate nput growth usng revenue shares, whereas wth mperfect competton the productve contrbuton of these nputs exceeds the revenue share by the markup. The thrd term s the value-added-augmentng resdual. Hence, V The frm's revenue-weghted value-added productvty resdual, dp, equals dv dx. s V V V M dp 1dx 1 dm dydt. 1 sm (12) Frm-level productvty growth measured n terms of value added depends n part on markups, as 7

13 emphaszed by Hall. In the presence of mperfect competton, however, productvty growth also depends postvely on changes n the relatve ntensty of ntermedate-nput use. B. Aggregatng over Frms We now aggregate over frms. In what follows, aggregate may be taken to refer to the ndustry level, or to the entre prvate economy. Changes n the resdual, ncludng technology shocks, clearly affect measured aggregate productvty. In addton, aggregate productvty depends on changes n aggregate prmary nputs, changes n the dstrbuton of nputs across frms (when nputs have dfferent margnal products n dfferent uses), and changes n the ntensty of ntermedate nput use. Aggregate productvty growth s the dfference between the growth rates of aggregate V output, dv, and aggregate nputs, dx. In growth rates: N dv w dv, (13) where w s the frm's share of nomnal value added, w P V V P V V. Wth some algebrac manpulaton, we can wrte aggregate prma ry-nput growth terms of the weghted average of frm-level nput growth, and reallocatons of captal and labor: where N 1 1 V dx V V dx w dx R R, (14) K L N V P K PK RK ws, 1 K dk PK N V P L PL RL ws. 1 L dl PL Combnng equatons (13) and (14), above, and notng that the frm-level value-added productvty resdual, dp, equals V dv dx, we can wrte aggregate productvty as: n 8

14 N 1 dp w dp R R. (15) K L As we have defned the nput prces, they represent dfferences n shadow values across uses (whch may or may not be reflected n factor-prce dfferences). 5 Thus, aggregate productvty s the weghted average of frm-level productvty shocks, plus reallocatons of captal and labor among uses wth dfferent shadow values. If resources shft towards more hghly valued uses, then aggregate productvty can rse even wth no change n any frm-level resdual. By substtutng from equaton (12) for dp and manpulatng, we can wrte aggregate productvty n terms of aggregate nputs, reallocatons of resources, and a resdual that ncludes technology: where, dp ( V 1) dx V R R V R V R dt (16) M K L V 1 1 V w, R w dx N V s M RM w 1, 1 dm dy 1 sm dt N N V V V 1 N w dt., and We defne the sum of the reallocaton terms as R, where V R R R R V R. (17) M K L Equaton (16) relates aggregate productvty and aggregate technology. If every frm s perfectly compettve and pays the same prce for factors (perhaps because factors are completely moble), then all terms other than dt dsappear, and productvty growth equals techncal change. However, wth mperfect competton or frctons n product or factor markets, productvty and 5 Note that n practce, an mportant reason these terms may exst s that workers who have dentcal observable characterstcs (that s, same age, educaton, etc) are not, n fact, dentcal. Then the reallocaton terms may reflect msmeasurement of nputs due to unobserved heterogenety. 9

15 technology may dffer. 6 III. The Sources of TFP Dfferences We now dscuss possble sources of TFP dfferences between Canada and the Unted States. In so dong, we use the framework that we have developed n Sectons I and II. However, we also dscuss ssues that are outsde the framework but stll mportant to nvestgate. A. Data Clearly, TFP growth rates may dffer across two countres f they use substantally dfferent methods for estmatng real output growth. (In prncple, dfferences n computng real nput growth rates can have the same effect, but n practce these dfferences are too small to explan a substantal part of the observed gap.) In partcular, the U.S. BLS has sometmes been accused of over-adjustng for the qualty mprovements of new computer and electronc equpment, whch would make measured U.S. output and TFP growth too hgh. It s lkely that the careful work of Rao, Tang and Wang (2008) controlled for ths source of error n comparng Canada and the Unted States, but snce t s a logcal possblty t needs to be mentoned. Basu, Fernald, Oulton and Srnvasan (2003) were conscous of ths potental for bas n dong ther cross-country comparson of the Unted States and the Unted Kngdom. Ther method to control for t was to use U.S. deflators for the hgh-tech manufacturng ndustres, only multplyng these by the pound/dollar exchange rate before applyng them to UK data. One 6 Jorgenson, Gollop and Fraumen (1987) derve an equaton for the case of constant returns to scale and perfect competton, so that dp dt. Thus, they omt the terms other than R and R. They also allow for K L heterogenety n captal and labor, whch we have gnored for smplcty. Wth heterogenety, our results generalze easly: For example, f R s the factor-prce reallocaton term for captal of type k, then R Kk K R. k Kk 10

16 could do the same for Canada and the Unted States as a robustness check, and see whether ths adjustment helps elmnate the acceleraton n the labor productvty gap n the 2000s. A dfferent data concern, common to both Canada and the Unted States, s that much of the growth acceleraton n the last 10 years has come n the servce ndustres. Three large servce ndustres make a substantal contrbuton to the labor productvty gap between these two countres (Rao, Tang and Wang, 2008.) They are the Trade ndustres (Wholesale and Retal) and FIRE. These ndustres, especally the fnancal servces and nsurance ndustres n FIRE, present formdable obstacles to attempts to measure ther real output correctly. Here also, one needs to compare statstcal procedures n the two countres to ensure unformty, and perhaps mprove the best practce so that both countres can have better output, TFP and labor productvty measures for these key ndustres. 7 B. Returns to Scale The frst term on the rght-hand sde of equaton (16) shows that the average degree of returns to scale wthn an ndustry matters for explanng ndustry-level TFP growth. The equaton expresses the coeffcent n terms of the markup, but equaton (5) shows the close connecton between the two concepts. If there are zero profts, as suggested by the evdence dscussed n Secton I, then the two are dentcal, and the markup parameters n equaton (16) can all be nterpreted as the degree of returns to scale. If frms n Canadan ndustres have large fxed costs and are stll operatng on the downward-slopng portons of ther average cost curves, whle U.S. frms can spread fxed costs over many more unts of output, then returns-to-scale dfferences can explan some of the labor 7 See, for example, the analyss and suggestons of Wang, Basu and Fernald (2008) regardng the measurement of bankng output, whch are mplemented n U.S. data by Basu, Inklaar and Wang (2006) for nomnal output and Inklaar and Wang (2007) for real output. 11

17 productvty gap between Canada and the Unted States. Ths hypothess can be nvestgated by estmatng returns to scale usng ether ndustry or frm data. C. Allocatve Effcency Effects The man contrbuton of the analyss n Secton II s to demonstrate that ndustry TFP growth (as well as the level of TFP) depends on the degree of allocatve effcency. We have already dscussed the average returns to scale (markup) term, so t s easy to use that as a sprngboard for dscussng the term R, as defned n equaton (16). Ths term shows that, even controllng for the average returns-to-scale effect, ndustry TFP growth s hgher f frms wth above-average returns to scale (markups) have hgher nput growth (dx V ) than frms wth belowaverage returns to scale. Thus, the effcency of allocaton wthn an ndustry can make sgnfcant dfferences to the rate of TFP growth for the ndustry as a whole. The ntuton behnd the other allocatve effcency terms, collectvely called R n equaton (17), s smlar. In all cases, they have to do wth the fact that margnal products for the same factor (captal, labor or ntermedate nputs) may not be equalzed across frms. If margnal products are not equal, ndustry output and TFP wll depend on whether addtonal nputs go on average to hgh-margnal-product or to low-margnal-product frms. Countres that succeed n havng hgh rates of allocatve effcency have nsttutons that encourage hgh-margnal-product frms to expand and low-margnal-product frms to contract. Ths nsght s mportant for polcy, because many polcy decsons nfluence the rate of factor reallocaton from neffcent to effcent frms. These nclude, but are not lmted to, statemposed costs of hrng and frng, the ease of gettng permts to expand a frm or enter a market, enforcement of ant-trust polces to reduce barrers to entry, and support for lad-off workers to retran, learn new sklls and fnd jobs at expandng frms. 12

18 Ths s the most dffcult and data-ntensve part of the suggested research. Frst, to construct an ndex of allocatve effcency for an ndustry, t would be necessary to have access to frm-level data for frms n that ndustry. To compare Canada and the Unted States, t would be necessary to have frm-level data for the same ndustres n both countres. Second, f t were found that the Unted States has hgher levels of allocatve effcency, t would be necessary to correlate allocatve effcency wth polces. Ths mght be done by usng varaton n laws/regulatons across Canadan provnces and U.S. states. Fnally, one would need to fnd or construct measures of exogenous polcy change, to overcome endogenety ssues. D. The Measure of Our Ignorance Most economsts thnk automatcally that TFP measures techncal change, but equaton (16) shows that t measures many thngs. One of them s surely techncal change. But before we dentfy the resdual dt term n (16) solely wth techncal change, t s mportant to thnk about what else t mght represent. By defnton, dt s the porton of productvty growth that s not explaned by ether the average markup/returns to scale effect, or by the varous reallocaton terms. It ncludes techncal change, but also has other components. Msmeasurement Msmeasurement of the qualty/quantty of nputs mght be one component of dt. For example, f workers have more human captal than they are measured as havng, the extra boost to output from hghly-sklled labor may be mstakenly attrbuted to techncal change. Msmeasurement of ntermedate nput and captal qualty s a partcular worry when dealng wth dsaggregated data. For example, n the U.S. productvty growth spurt that started n the late 1990s, many of the largest contrbuters to the productvty acceleraton were servce 13

19 ndustres (fnance, retal trade and wholesale trade). These were also all ndustres that nvested heavly n nformaton technology (IT). IT s a form of captal that has mproved tremendously n qualty over tme. If the prce deflators for IT do not capture ths mprovement fully, then the contrbuton of captal to servce output growth wll be overstated and the contrbuton of the resdual to TFP growth would be overstated. Ths problem can be severe for dsaggregated ndustres (and a fortor for frms). It s less problematc as one studes productvty at hgher levels of aggregaton. For example, n the IT example, the output of the IT-producng sector s based downward, as s the nput of the ITusng sector. If the IT s used by other domestc ndustres as an ntermedate nput, then the bas cancels at the aggregate level wthn the perod. However, even f IT s used as captal, the average bas over longer perods of tme wll be small. Of course, n an economy that s open to trade, the bas from msmeasurng the real quantty of ntermedate goods need not wash out n the aggregate. Infrastructure The nput T n a frm s producton functon, equaton (3), s best defned as any factor that affects producton but s not drectly compensated by the frm. Government-provded nputs of nfrastructure are a case n pont. (Nowadays, one also thnks of dgtal nfrastructure as a key nput that mght be provded by the government.) Aschauer (1989) argued that physcal nfrastructure bult by the U.S. government has hstorcally been hghly productve, accountng for a large fracton of aggregate TFP growth. Aschauer uses a OLS regresson approach to estmate the benefts of nfrastructure, leadng to a concern that the estmate may be based upward. Fernald (1999) uses an nnovatve estmaton strategy to control for the endogenety of nfrastructure, and also estmates a hgh average rate of return to road-buldng specfcally. 14

20 However, Fernald s results suggest that the margnal product of new spendng on roads s sharply lower than the hgh average product of the pror spendng that created the U.S. natonal hghway system X-Effcency/Management Practces The assumpton that frms mnmze costs underles the dervaton of both equaton (6), at the frm level, and equaton (16), for aggregate productvty growth. Lebensten (1966) suggested that frms may not produce the maxmum output attanable for a gven set of nputs, and labeled the gap between the two X, standng for unknown. In a smlar ven, Smon (1957) proposed that agents mght satsfce try to acheve a target that s good enough, nstead of actually maxmzng. If the extent to whch frms maxmze changes over tme, then the resultng gan n effcency wll show up n the resdual, although t wll not be due to techncal change. To some extent, the dstncton between the two s defntonal, but from a polcy perspectve, the polces that lead to faster techncal change (dscussed below) are qute dfferent from those that mght lead frms to deploy ther exstng nputs more effcently. Recent papers have sought to gve content to the X n varous ways. One of the most promsng s to consder management practces and how they dffer across countres. In an mportant paper, Bloom and van Reenen (2007) found that the qualty and professonalsm of managers vares sgnfcantly across countres, n a way that s correlated wth the productvty and proftablty of the companes they run. It s not clear from ther cross-sectonal study how much of the tme-seres varaton n productvty mght be explaned by such management dfferences, but any such changes would contrbute to the dt term n (16). Externaltes 15

21 In prncple, both hgh- and low-frequency externaltes can contrbute to a resdual term n equatons lke (6) and (16). Hgh-frequency externaltes are often nvoked n busness-cycle theory, but there are few convncng descrptons of how these externaltes mght operate. Over long perods of tme, however, knowledge externaltes from R&D spllovers, reverse engneerng and mtaton assuredly exst, and may be mportant. Externaltes are partcularly mportant n a polcy sense, snce they create a prma face case for government polces to subsdze prvate R&D or do publc R&D. It s worth notng, however, that whle there s agreement that knowledge does spll over between frms, there s no consensus about the magntude of these effects. Svekauskas (2007) revews a number of studes, and concludes that frm (as opposed to government or unversty) R&D has a socal return that s about two to three tmes the prvate return (.e., an externalty that s up to twce as large as the drect prvate effect). But the underlyng studes have large standard errors for the key coeffcents, so ths s an mprecse estmate. True Techncal Change It s of course possble that the gap n labor productvty that we seek to explan s due to dfferences n the rate of underlyng techncal change n Canada and the Unted States. True techncal change s the resdual of the resdual what remans when we have removed everythng else that we can measure. 8 If ths hypothess s correct, then the mplcatons for polcy are rather dsmal. The reason s that despte decades of effort by great economsts, the dt term conceptually, though not 8 As a matter of prncple, based on the dscusson above dt should be classfed as the free part of techncal change deas that fall lke manna from heaven, as t were. Techncal change that results from purposeful R&D nvestment should be classfed as output due to captal accumulaton. However, tradton allocates the output growth resultng from nvestments n R&D to the resdual. We contnue to keep t there to mantan conformty wth the exstng lterature, whle notng the nconsstency. 16

22 lterally, the resdual that Abramovtz (1956) called a measure of our gnorance s not much better understood now than t was when Abramovtz wrote. The usual way to explan the resdual usng deeper measures of knowledge creaton s to examne the effects of nvestment n R&D and patentng actvty by frms/ndustres as well as the relevant publc-sector nvestments, bearng n mnd that knowledge creaton often has spllovers and s subject to long lags. However, Grlches (1994) summarzes 40 years of research on these topcs by wrtng, But the magntude of the estmated effects [of R&D on productvty] was modest, not enough to account for the bulk of the observed resdual or fluctuatons n t. Thus, f the labor productvty gap between Canada and the Unted States reflects mostly true dfferences n the levels of technology n the two countres, then approprate publc polcy measures are hard to fnd. Surely, subsdes for R&D or more fundng for basc research are lkely to do some good. But t s dffcult to fnd evdence that such nvestments can close even a substantal fracton of an ndustry-level TFP gap. IV. Polces for Prosperty An Overvew In the prevous secton, we developed a framework for analyzng productvty growth, whch s the ultmate determnant of welfare change. To summarze, we have seen that equatons (16) and (17) can be combned nto a smple schematc relatng productvty growth to an average markup/returns to scale, an allocatve effcency effect, and a resdual: ( V V dp 1) dx R dt, (18) where dt s partly explaned by deeper underlyng varables: dt = G(nfrastructure, externaltes, free techncal change, management, own R&D). (19) 17

23 A large number of mcroeconomc studes have tred to mplement a productvty decomposton along the lnes of (18), and have come to mxed conclusons about the relatve mportance of allocatve neffcency as a drver of productvty growth. However, wth rare exceptons, ths lterature confnes tself to examnng the hstorcal decomposton, whch can tell us how mportant allocatve effcency has been n the past. But ths lterature generally does not try to answer the counterfactual queston that s mportant for polcy: How much extra productvty growth could we get by promotng polces to mprove allocaton? What polces would attan ths objectve most effcently? Several large lteratures have tred to understand how dt s determned by one or more of the varables lsted n equaton (19). These attempts typcally come closer to addressng polcy ssues, snce they try to uncover the structural effect of R&D captal, nfrastructure, etc., on the resdual. Other research agendas for example, the nvestment lterature try to estmate the effects of polces such as R&D subsdes on the actualy quantty of R&D. Puttng the two together, one can get a sense of the extent to whch polcy can nfluence productvty growth. In prncple, polces could affect aggregate productvty growth by changng any of the three man components n (18), ether drectly or va any of the sub-components of (19). Polcy evaluaton, n turn, can be done by seeng how the polcy n queston affects one or more of the components, or by tryng to ascertan drectly how the polcy affects the varable of ultmate nterest, aggregate productvty growth. The ssues wth such regressons can also be dscussed n a schematc way. Suppose we have panel data for a group of ndvdual enttes, whch may be frms, ndustres or countres. We wsh to see how an outcome varable, Y, s affected by polces, X, when another varable, Z, also affect the outcome. Assumng a lnear relatonshp for smplcty, we have 18

24 Y X X Z Z (20) t t t t t t t The full effect of a polcy change on the outcome varable s gven by the partal dervatve Y X t t Z t. (21) Note that the polcy must vary both across unts and over tme n order to dstngush from the ndvdual and tme fxed effects, and. But f the ndvdual observatons are at the frm or ndustry level, then many of the most nterestng polces such as labor market regulatons are the same across all unts. Others, such as nvestment or R&D subsdes for partcular ndustres, may be fxed over tme. If there are nteractons between the effects of polces and ndvdual characterstcs, summarzed by Z, then one would be able to dentfy part of the polcy effect, the Z term n (21). But ths s obvously not the full effect of the polcy. Another major concern n such regressons s that the polcy may be endogenous that s, X may be correlated wth the error term. For example, regulaton may be drven n part by economc outcomes. To some extent, ths problem s amelorated by havng ndvdual and tme effects n the specfcaton. For example, f regulaton s drven by aggregate shocks, or f tarff protecton s enacted to help a declnng ndustry, then the endogenous porton of the polcy wll be swallowed up by the tme and fxed effects. However, t s the same fxed and tme effects that cause problems for dentfyng the full effects of polcy, as gven n equaton (21). Once agan, we see a standard tenson between keepng a lot of the varaton n a rght-hand-sde varable to ad n dentfcaton, versus excludng much of the varaton n an effort to reduce bas. The norms of the economcs professon suggest a strong preference for dentfyng part of the polcy effect wthout bas, rather than all of t but wth less precson. Thus, most of the 19

25 emprcal work on polces and growth n developed countres use specfcatons lke (21), and settle for estmatng a statstcally sgnfcant coeffcent. But these papers typcally do not ask whether polces account for a large fracton of productvty growth dfferences across frms, ndustres or countres. Nor do they ask whether plausble changes n polces could have a major effect on productvty growth. Thus, the polcy effects lterature makes a compellng case that polces do have an effect on economc growth, and dentfy some of the channels through whch these effects work. But much of ths lterature s not helpful for askng whether polces have effects that are economcally rather than statstcally sgnfcant. The next several sectons go nto these ssues n more depth, and summarze mportant papers. 9 V. Reallocaton and Growth: Theory and Evdence A varety of economc polces product market regulatons, labor market regulatons, and trade barrers can affect the allocatve effcency of an economy. Frst, they mght change the allocaton of resources between sectors producng dfferent goods and between frms wth dfferent productvtes wthn each sector. Second, they can affect the pace of entry and ext, and thus change allocaton n a dynamc sense. Blanchard and Gavazz (2003) dscuss the effect of product and labour market regulaton on employment and wages n the context of a model of dentcal mperfectly compettve frms where both the product and labour markets are non-compettve. In ths model, an ncrease n product market reform s modelled ether as an ncrease n the degree of substtutablty between goods or as a decrease n the entry cost. 9 Sectons V-VII draw heavly on Schantarell (2008). I am grateful to Fabo Schantarell for sendng me hs paper and allowng me to quote from t extensvely. 20

26 In ther model, the effect of product market reform may dffer between the short run and the long run. An ncrease n the degree of substtutablty between goods leads n the short run, for a gven number of frms, to lower markups, ncreased employment and hgher real wages. However, there s no effect n the long run, because the reduced markups nduce frms to ext. Product market reforms that lead to a decrease n entry costs, on the other hand, have long-run effects as well. The entry of new frms wll be assocated wth a lower markup and hgher employment and real wages. One of the man polcy mplcatons of the paper s that only polces that affect the cost of entry have long run effects, and hence are the ones that should receve the greatest attenton. 10 Another class of models allows for heterogenety between frms. Bernard, Eaton, Jenson, and Kortum (2003) and Meltz (2003) focus on external barrers affectng the product market and are based on the assumpton of heterogenety n productvty. These papers allow for entry and ext of frms and show that a lowerng of trade barrers generates a reallocaton of resources towards more productve frms. The ext of low productvty frms and the expanson n the domestc and foregn markets of hgher productvty frms gves rse to aggregate productvty growth from polcy change. 11 Bergoeng, Loayza and Repetto (2004) also allow for dosyncratc heterogenety dfferences n productvty and focus on how the effect of a negatve aggregate productvty shock depends upon government nduced rgdtes n the reallocaton of resources, modelled as a subsdy to exstng frms. Smulaton exercses show that the exstence or the ntroducton of 10 The effect of labor market reform, captured by a decrease n workers barganng power n a Nash cooperatve bargan, wll lead to a decrease n the real wage n the short run, but to an ncrease n employment and an unchanged real wage n the long run n the Blanchard and Gavazz model. 11 For recent mcro evdence on foregn competton and trade reform see Pavnck (2002), Harrson and Revenga (1995), Harrson (1994), Levnsohn (1993). For cross-country evdence on trade lberalzaton see Rodrguez and Rodrck (2001), Vamvakds (2002), and Yankkaya (2003). 21

27 such subsdes ncreases the length of the perod n whch aggregate output s below potental and generates greater cumulated output losses. Restucca and Rogerson (2003) and Hseh and Klenow (2006) develop models n whch government generated dstortons result n heterogenety n returns to captal and labour across frms and n msallocaton of resources. Ths msallocaton may lead to much lower levels of aggregate TFP, as shown by Hseh and Klenow (2006) usng plant-level data for Inda and Chna. Several other mcro-econometrc contrbutons address the effect of regulatory reform and prvatzaton on productve effcency or productvty growth. The overall concluson s that n many nstances there have been productvty gans due to ncreased competton. 12 Olley and Pakes (1996) wrote an mportant paper on the effect of regulatory reform on the dynamcs of productvty n the US telecommuncaton ndustry. They decompose aggregate (weghted) productvty levels between un-weghted average productvty and a cross term that captures whether more effcent frms have greater market shares. They use ther estmate of producton functon parameters that control for endogenety and sample selecton to show that mproved aggregate productvty performance at the ndustry level s due to a reallocaton of output to more productve plants and not an ncrease n the un-weghted average productvty. In addton to the statc productvty level decomposton due to Olley and Pakes (1996) Baly, Hulten and Campbell (1992) have proposed a method to decompose aggregate productvty growth n dfferent components. Ther contrbuton has been refned by Grlches and Regev (1995) and by Foster, Haltwanger and Krzan (2001). The basc dea s to break down aggregate productvty growth n a wthn component (comng from productvty 12 For good revews, see Ahn (2002), Ahn (2001), and Fan et al. (2005). 22

28 mprovement n contnung frms), a between component (due to the reallocaton of resources between contnung frms), and of the component due to entry and ext. 13 The refnements attempt to deal wth the overestmate of the contrbuton of enterng and extng frms nherent n Baly et al, by ntroducng reference productvty values n calculatng the contrbuton of such frms. Results on the relatve mportance of each component of total productvty growth decompostons dffer accordng to whch decomposton s used, to whether one focuses on mult-factor or labour productvty, whether one uses employment or product weghts, whether they are begnnng of perod or an average between the begnnng and the end of perod, and accordng to the length of the horzon chosen for the calculaton. Many estmates of the wthn component of labour productvty mply that t tends to be the most mportant component, although ts weght vares across studes. In terms of equaton (22), these results mply that the contrbuton of the R term s small. Bartelsman, Haltwanger and Scarpetta (2004) fnd ths result (a small contrbuton of R) both n developed and non-transton emergng countres. Foster, Haltwanger, and Krzan (2001) show that the contrbuton of entry and ext (net entry) to aggregate productvty becomes mportant (and postve) only at a 5/10 year horzon, reflectng the ncreasng share of enterng/extng frms and learnng/selecton effects. Bartelsman et al (2004) also show that entry s more mportant (and has a postve productvty effect) n most transton countres. The entry contrbuton tends, nstead, to be negatve n most OECD countres and n the non-transton emergng economes, whle the ext effect s always postve. Evdence on the mportance of reallocaton of market shares from low to hgh productvty contnung frms s also mxed. For nstance Grllches and Regev (1995), and Scarpetta, 13 See Haltwanger (2000) and Ahn (2001) for a revew. In some decompostons, n addton to the wthn, between and entry/ext component s there s also a cross component. 23

29 Hemmngs, Tressel and Woo (2002) fnd that t s small, whereas Baly, Hulten and Campbell (1992), and Foster et al. (2001) fnd t s mportant. Recently Meltz and Polanec (2008) have argued that even the Grlches and Regev (1995) and Foster et al. (2001) decompostons underestmate the contrbuton of survvng frms and overestmate the contrbuton of enterng frms and propose a new decomposton based on Olley and Pakes (1996) that ndeed enhances the emprcal mportance of productvty developments for the set of contnung frms, partcularly of the between component. VI. Innovaton and Polcy: Theory and Evdence In ths secton we start from a dscusson of a few theoretcal contrbutons that help us n understandng the complex lnks that exst between economc polces and changes n what we term dt n equaton (23). Many of these polces are n the area product market regulaton. Polcy changes can have a drect effect on the productve effcency of exstng frms. Greater competton may ncrease the ncentves to reduce X-neffcences, and organze work more effcently. The theoretcal lterature s mmense and, whle agency models of manageral behavour can ratonalze why greater competton tends to reduce slack, ths concluson s by no mean unambguous. The channels of transmssons are manfold (see Nckell, Ncoltas, and Dryden, 1997). Frst, n a more compettve envronment t may be easer for owners to montor managers because there are greater opportuntes for comparson whch can lead to better ncentves. Second, t s plausble that an ncrease n competton wll ncrease the probablty of bankruptcy and managers wll work harder to avod ths outcome. Thrd, n more compettve markets characterzed by hgher demand elastcty, a reducton n costs that allows frms to lower prces wll lead to a larger ncrease n demand and, potentally, profts. 24

30 Changes n ownershp from publc to prvate may also have mportant effects on the ncentves for managers and workers to reduce slack. Whether or not that happens crucally depends on the market structure after prvatzaton. One must be careful, n general, not to equate prvatzaton or deregulaton automatcally wth an ncrease n compettve pressure, partcularly n sectors where ncreasng returns create ncentves for the emergence of natural monopoles. There are several prncpal-agent models that study the effectveness of ncentves and ts dependence on the number of players. Hart (1983) addresses more drectly the lnk between competton and performance. In hs model, a fracton of frms are run by managers who respond only partally to monetary ncentves, n the sense that they care only whether or not ther ncome exceeds (or not) a mnmum level. The resultng optmal contract conssts of payng managers ths mnmum provded frms profts exceed a gven floor (that can be nterpreted as the bankruptcy level), and zero otherwse. In ths stuaton, any shock that nduces proft maxmzng frms to reduce costs wll be transmtted, va lower equlbrum prces, to non-proftmaxmzng frms. Ther managers wll also try to reduce costs n order to avod bankruptcy and preserve the utlty derved from beng n control of the frm. Ths wll lead to an ncrease n the level of productvty n the economy. Product market reforms may affect not only the level of productvty, but also ts growth rate through the effect that greater competton has on the ncentves to ntroduce new products or processes that replace the exstng ones. The vew by Schumpeter (1942) of growth as a process of creatve destructon, n whch the ntroducton of new processes and products s assocated wth the destructon of old ones, underles many recent papers, such as the endogenous growth models of Aghon and Howtt (1992) and Grossman and Helpman (1991) 25

31 and the contrbutons by Caballero and Hamour (1994), (1996), (1998). Impedments ntroduced by product or factor market regulatons to reallocaton of factors of producton away from low return actvtes to hgh return ones may have adverse effects on an economy s aggregate performance. 14 In endogenous growth models, for nstance, product market regulaton may be seen as ncreasng the cost of ntroducng an nnovaton. However, there are contrastng forces at work. In Schumpeter s (1937) thnkng, the expectatons of monopoly profts provde the crucal ncentve for nnovatve actvty. A decrease n monopoly profts followng regulatory reform may, therefore, decrease the pace of nnovaton and hence growth. In addton, the degree of market power also affects the ablty to nnovate snce t allows the accumulaton of nternal fnancal resources that can be used to fnance nnovaton. These nternally generated funds are crucal n the presence of nformaton asymmetres that may make t dffcult or expensve to obtan external funds for nnovaton actvtes. Indeed n the early qualty ladder endogenous growth models by Aghon and Howtt (1992) and Grossman and Helpman (1991) and n the product varety model by Romer (1990) a reducton n rents generated by regulatory changes would adversely affect the ncentve to nnovate and, hence, decrease steady state growth. 15 Thus, product market reform n the form of trade lberalzaton could have ambguous effects on growth, snce the postve scale effect s counterbalanced by the (negatve) effect generated by smaller rents that accrue to nnovators. Note that whereas n the product varety models the decentralzed growth rate tends to fall short of the one chosen by the socal planner, n qualty ladder models of creatve destructon ths 14 See also Parente and Prescott (1994) who argue that the productvty gap across countres s due to excessve regulaton that dscourages the adopton of new technologes and protects poorly performng frms, thereby slowng the convergence to the world technology fronter. 15 In the endogenous growth models revewed here, regulatory reform can be thought of as ncreasng the prce elastcty of demand, or decreasng the cost of entry (ncreasng the probablty of entry), or decreasng the cost at whch a compettve frnge can produce.. 26